If you are studying macroeconomics at school or colleges, I am sure you must have gone through the topic of exchange rates somewhere. In todayâ€™s highly commercialized world, every country deals economically with a large number of other countries.Import and export between partner countries usually involve currency exchange.Effective exchange rate help homework elaborates on how countries regulate currency exchange rates with partner countries.
Why the need of effective exchange rate?
Trading between countries entails traders and investors to juggle between different currency rates and other trade related figures.Market conditions and other indicators also vary in different countries. Economists and world forums have devised certain standards of exchange rates over the years.
I came across a few concepts on exchange rates while going through the views in effective exchange rate help homework.Related to the very popular term purchasing power parity, effective exchange rate is a rough guide to a countryâ€™s financial position. While purchasing power parity keeps the US dollar as the baseline, effective exchange rate calculates a figure for the host countryâ€™s currency relative to currencies of other countries.
When you deal with bilateral trade activities between two countries, you work on a currency pair. It becomes simple to compare the currency power of the two countries. Effective exchange rate helps in handling trade mathematics of a country trading with multiple other countries.
What is effective exchange rate?
Effective exchange rate help homework mentions effective exchange rate as an index that measures the power of a countryâ€™s currency in relation to a basket of other currencies of other countries. The currencies in the basket are usually of the most important trade partners.
I read about the different variations of effective exchange rates and the ways of calculating these in different scenarios.Go through the mathematical formulas representing effective exchange rate in effective exchange rate help homework notes. Macroeconomics and allied studies discuss extensively these in matters of international trade, forex market, and multinational trading relations.
Nominal Effective Exchange Rate
You will frequently come across nominal effective exchange rate, which is simple weighted average of bilateral exchange rates of a countryâ€™s currency with those of partner countries. No such international standard exists for selection of basket of currencies that comes into play. Most often countries follow the guidelines of the International Financial Statistics published by the International Monetary Fund.
Nominal effective exchange rate indicates the external competitiveness of a country.It compares the currencies of the most important partner countries with that of the host country in a weighted average. It indicates the actual purchasing power of currency.
Real Effective Exchange Rate
Real world trading between partner countries involves important factors like price inflation and labor cost inflation. These need to be included in any trade index calculation. If I take the nominal effective exchange rate and adjust it to include inflation rate differences between partner countries, I get the real effective exchange rate.
Effective exchange rate help homework tells you that real effective exchange rate can be obtained by averaging bilateral real effective exchange rates with trading partners and weighing the trade allocations of every partner country.
Real effective exchange rate captures the external competitiveness of a countryâ€™s currency in the true sense.Inclusion of inflation values and placing appropriate weights on these are very important because of varying trade scenarios in different partner countries.
Countries select the currencies of the most important trading partners, and their values are weighted by the value of trade with the partner countries. The value figure can be the import and export value or the total value of import and export with the partner country.
As there is ample similarity between purchasing power parity and effective exchange rate, both techniques are used in modern macroeconomics.
Remember that import and export value factors are to be included while calculating real effective exchange rate. An increase in the real effective exchange rate means exports have become more expensive and imports cheaper. In other words, trade competitiveness of the country goes at a loss.
Significance of effective rates
Concepts of nominal effective exchange rate and real effective exchange rate are important indicators for a countryâ€™s financial prowess in the forex market. Effective exchange rate indices are volatile over short periods of time. As selling and buying rates differ in different countries, their individual effective rates are also varied.
The effective currency rate calculations are significant for traders, investors and government alike. It largely shows the financial competitiveness of a country and helps to maintain trading parity among partner countries.
Take guidance from effective exchange rate help homework on concepts of effective exchange rate and its significance in the forex market. The indices also greatly influence policy and economic analysis in international trade.In order to stay abreast with international trading competencies countries worldwide make use of exchange rate tools effectively.
Although effective exchange rate is not an ideal choice to compare standards of living in different countries, it fairly represents the relative power of a countryâ€™s currency in light of its trading partners.